How Reinvested Dividends Can Double Your Return in Stocks

Last week in The Daily Reckoning, Greg Canavan and Dan Denning wrote about how owning shares that pay you to own them will be key to your investment success in the coming years. With the big four banks – traditionally high dividend players – being downgraded by Standard and Poor’s overnight, we thought it was a great time to revisit why dividends are important and how to safely buy the companies that issue them.

We’ve ‘mashed-up’ the best bits of Dan and Greg’s essays below. Enjoy… And if you want to find out which five Aussie dividend payers Greg has buy recommendations on right now, go here.

Why Invest in Dividend Stocks?

Widespread deleveraging is going to favour some investments over others.

And in general, it will probably favour regular income (dividends) over capital gains. That’s about what you’d expect in a low-growth/no-growth environment. Investors will demand a higher yield to compensate for lower capital growth.

Why should you begin to focus on dividends? Because for years they have been of secondary concern. Most investors have just lived through a 25-year bull market – if we take 1982 as the starting point and 2007 as the end point.

That’s 25 years where capital gains were the main source of an average return. Dividends were just a bit of a bonus, but not the main game. Capital gains were dominant as a source of returns because of the secular decline in interest rates and everything that goes with this: Debt growth, cheaper speculation and asset price bubbles.

But this wasn’t always the case. In fact, in normal times (without the benefit of a credit boom) reinvested dividends may be far more important to the performance of your common stocks than capital gains. The chart below from the 2002 book, Triumph of the Optimists, certainly makes that point clearly. It shows that for a one hundred year period, total returns in US and UK stocks with reinvested dividends are twice the returns of stocks with capital gains only.

How Reinvested Dividends Can Double Your Return in Stocks over Time

Source: Triumph of the Optimists

You’ll note the chart ends in 2000. It includes the Internet boom in the markets, but not the bust. And of course, in the 11 years since then, markets have been heavily influenced by lower interest rates, central bank intervention, and quantitative easing. Globally low interest rates also made it less imperative for companies to pay dividends to shareholders. Companies could borrow cheaply and lever up to grow earnings. It was a market for chasing capital gains in a global boom.

But in the scheme of things, it’s the last 10 years of debt binging that are anomalous, not the previous 100.

Managing Your Dividends

That means we’re returning to a market where dividends will be far more important to your total return than they have been in the last 10 years. As financial analyst Robert Arnott wrote in 2003, “Unless corporate managers can provide sharply higher real growth in earnings, dividends are the main source of the real return we expect from stocks.”

Return Of The Prudent Manager

This is encouraging news. It means the return of genuine security analysis is now on the horizon – after the great deleveraging. Investors will again have to assess which corporate managers do the most with your money. In technical terms, you’re looking for managers who generate consistently high returns on equity.

Ever since executive compensation has been tied to quarterly earnings performance in the US, US corporate managers have borrowed heavily to lever up the balance sheet and deliver quarter-over-quarter earnings growth. They were more interested in delivering earnings surprises to push the share price higher because that directly influenced their yearly pay packet.

You could make a pretty hefty argument that this mis-aligned the incentives of shareholders and corporate managers. The capital management of US firms became short-sighted, short-term, and dominated by growing quarterly earnings by any means necessary. This was particularly true, for example, for firms like Fannie Mae and Freddie Mac.

Return of the Dividend

Shareholders, to the extent, they cared at all, decided to chase capital gains and leave the valuation game to the dinosaurs like Buffett. But we may now be swinging back to a market where capital management matters again to investment returns. And retuning those returns on investment to the investors via dividends. That’s what happens when you take away the balance-sheet boosting powers of easy money and credit. Growth takes a back seat to cash flow earnings. Suddenly divvies start to look enticing.

This is a return to cyclical norms. The good folks at Tweedy Browne in the States published some research a few years ago which shows that, “a market-oriented portfolio, which included reinvested dividends, would have generated nearly 85 times the wealth generated by the same portfolio relying solely on capital gains.”

The Good, Old-Fashioned Magic of Reinvested Dividends

It’s the sort of boring fact that the investment industry doesn’t generally alert you to. And to be fair, it’s not very exciting. At all. But it does appear to be true, at least up to about 2003, that reinvested dividends massively increase your total return in common stocks over time.

Investors take a while to realise the bull market is long gone. It’s been just four years since the market peaked back in November 2007 and we’d guess there are plenty of punters who think the next bull market is just around the corner. Maybe they think we turned that corner last week?

Having a massive financial industry that was created out of the last bull market makes it difficult to effectively communicate the reality of the situation. There’s no shortage of self-interested opinions telling people (as they’ve been doing for the last four years) that every pullback is a buying opportunity.

So in a world where long-term capital gains are all-but non-existent, dividends will again receive the respect they deserve.

Bill Gross of PIMCO didn’t say all this exactly in his latest investment outlook but the gist was the same:

Investors should recognise that Euroland’s problems are global and secular in nature, reflecting worldwide deleveraging and growth dynamics that began in 2008. It will be years before Euroland, the United States, Japan and developed nations in total can constructively escape from their straightjacket of high debt and low growth. If so, then global growth will remain stunted, interest rates artificially low and the investor class continually disenchanted with returns that fail to match expectations. If you can get long term returns of 5 per cent from either stocks or bonds, you should consider yourself or your portfolio in the upper echelon of competitors.

A 5 per cent long-term return from the stock market sounds pretty ordinary. But that’s the thing – a bear market is not ordinary. It’s worse than ordinary. In a bear market, your job is to not lose money.

Keep Your Capital Intact And Get Ready To Have
A Swing When The Next Cycle Gets Underway.

That last point is probably the most important one: timing. You HAVE to be a market timer today in order to put these observations to use. First off, it’s of no use understanding the next big trend in financial markets if the current trend (the other side of the hurricane) wipes your capital out.

The only real goal you should have in a bear market is to not lose money.

And we’re still in a bear market.

How Reinvested Dividends Can Preserve Your Assets

But this is the encouraging thing. As the Austrian economists point out, the recession is the correction to the credit excess. The recession IS the healing to the economy, inasmuch as bad investments are liquidated and imbalances corrected. Eventually, market forces will over-run political and monetary intervention and return asset prices to a level commensurate with their power to generate real earnings in a real economy.

We are in the middle of the creative destruction right now. We’re closer to the end than the beginning. But we’re not there yet. But when we do get there, if you have your capital intact, it will be the last best chance of your investment lifetime to buy a portfolio of solid businesses. Then, you can let the magic of time compound your returns and reinvest your dividends.

Our suspicion is that for anyone planning to retire in the next 10 years, the next cycle of growth is probably too far away to matter. Baby Boomers need to preserve their capital now and make it generate enough income to live off of for the next 20 years. Losing another 20-30% in capital is not an option, even if it means the end of the correction.

If we’re right about markets reverting to the mean and dividends reasserting themselves as the most important factor in your total portfolio returns, then the main beneficiaries will be your children and grandchildren.

They have time on their side, as long as they don’t rush in and lose all their money now.

Note: Greg Canavan has recommended five Aussie shares paying a dividend. The highest dividend on any of his outstanding recommendations is 10.2%. Though he doesn’t recommend shares purely for the dividend, how well management uses your capital to generate higher earnings is a key component of his value investing strategy.